In the realm of corporate governance, recent research has confirmed a finding that should instinctively make sense: When a company’s board has a higher proportion of independent directors, the company itself behaves in a more transparent way.
What’s less obvious is whether the greater transparency is a result of having more outside directors, or whether companies that put greater stock in transparency are more likely to acquire more outside directors.
Wharton professors Christopher Armstrong and Wayne Guay, along with John E. Core of MIT’s Sloan School of Management, delved into that question in a paper, “Do Independent Directors Cause Improvements in Firm Transparency?” published in the Journal of Financial Economics. In this interview with Knowledge at Wharton, Armstrong and Guay discuss their findings and explain what it takes for companies to improve governance and information flow, and why there are no “one size fits all” solutions.
An edited transcript of the conversation appears below.
Keeping watchdogs in the know:
Wayne Guay: The research focuses on the board of directors as being a cornerstone, a focal point of good corporate governance. The shareholders of a corporation appoint a board that then gets involved in the strategic decision making and monitoring management to make sure managers are doing what shareholders would like them to do.
Many of these individuals on the board are independent directors, meaning they’re independent of management, so they can act as a watchdog or a monitor of managers. But the tricky part there is to make sure those outsiders, those independent directors, are well informed about what’s going on at the firm. These are busy individuals with typically high-profile jobs. They’re only spending four or five or six days a year involved with the company. And so, it’s a critical issue as to how to make sure they have the information that they need to monitor and advise managers.
In this paper, we focus on: How do firms, how does management, how does the board of directors take actions to insure and have a degree of comfort that they’re getting good information that they can use to make good decisions?
Armstrong: The key takeaways are to realize the interconnection between information and monitors, and decision makers — that those two really need to go together. To have a certain type of director in place requires a certain type of information, environment or a certain level of transparency.
The big tension or trade-off when looking at boards of directors is between independent and inside directors. Inside directors are affiliated with the firm. They’re more involved day-to-day. They have a lot more background information. So, they’re not going to be as reliant on external information sources as an independent director, who is only going to be there five, six days a year typically. They need an information source that can get them informed, up to speed quickly to facilitate their decision-making, making sure they’re asking the right questions.
Armstrong: We’re [also] working on a survey paper with two other co-authors — one of them is at the research branch of the Fed. It’s focused on financial institutions. So, we’re trying to apply a lot of the things we’ve been talking about in the context of financial institutions and banks in particular.
“More and more of the decision-making in public corporations is in the hands of independent directors. And that’s only going to work if those independent directors have the information that they need.” –Wayne Guay
Surprises from the research:
Guay: I think what sort of surprised us — one of the interesting facts we observe in the paper — is that the relation between information and the structure of boards goes in both directions.
Specifically, trying to force upon a firm more independent, outside directors when that firm is informationally opaque — or if that firm has difficulty communicating information to outside directors — may not work. Those directors simply may not be able to get the information they need to do a good job.
At the same time, we also find that there is some element of, when you do force independent directors onto a board they do try to take actions to get better information. And so, it’s this very complex and dynamic information structure where the directors have some ability to force the firm to become more transparent. But at the same time, going too far and trying to have too many of the directors be independent can sometimes cause informational problems, where those directors simply aren’t able to get all the information they need.
Guay: There was a regulation that was passed in the early 2000s. Some of it was related to the major stock exchanges. And they required a majority of the board of directors to be comprised of independent directors.
Before that there were lots of boards that were dominated by inside directors, and this new regulation forced a majority to be outside or independent directors. When that happened, firms had to shift their Board structures dramatically. So, there was this exogenous shock, this regulation that forced these firms to add more independent directors.
And how do firms react to that? Do they struggle to get the information in the hands of those new independent directors? If prior to the regulation you had say, eight inside directors and two independent directors, and after that you had seven outside directors or independent directors and only three or four inside directors, somehow you have to get those outside directors up to speed on information.
So, we look at: Do firms change their financial reporting quality? Do firms use the auditing process in a different way? Do firms disclose more public information in the form of management forecasts or analyst forecasts? Does the firm take actions that would potentially get better information in the hands of directors, beyond just the internal information that the directors will get from managers. Simply asking managers to give us good information is often not good enough or will not a credible information source.
Chris Armstrong: The immediate consequence was these companies that didn’t have a majority of independent directors had to get a majority.
What’s the second level of consequences once those independent directors are there? Perhaps even before, while they’re trying to attract and get these independent directors — how do they make changes to the information environment to accommodate this new board structure that’s going to be in place after the regulations? The regulations are like the first domino that fell. And then we’re looking at subsequent consequences.
Misperceptions dispelled by the study:
Guay: I think that one of the common misperceptions in general with corporate governance is that there are certain best practices that firms can use. The notion of a single best practice in corporate governance is a misnomer.
“The notion of a single best practice in corporate governance is a misnomer.” –Wayne Guay
I don’t think it really describes the way corporate governance works. What might be a good practice for one firm could be a disaster for another firm or very costly for another firm. And so we focus on boards of directors and we make the point that simply forcing a firm to have lots of outside directors is not necessarily a good thing if those outside directors are going to be making decisions in the dark. Unless those outside directors are informed, they’re not going to be able to do a good job.
You can take that same idea and you can impose that on virtually every other simple governance structure. [In addition,] people often [say that] CEOs should not also be the chairman of the board, that there should be an independent chairman of the board. The CEO and those two roles should be separate.
And there’s extensive literature that shows that sometimes having the CEO be the chairman of the board is good, and sometimes having the CEO be the chairman of the board is bad. You can go right down the list with staggered boards, with executive compensation, with stock options and stock ownership, and just about every component of governance and it’s important to keep in mind that there simply is not one single best practice. But it needs to be conditional on the firm’s setting. And that’s the way people should think about it.
Armstrong: Even beyond that, just stopping to ask, well, why are there differences in the first place before we start trying to push everyone to the same direction. And thinking about, well, why do some companies already have a majority of independent directors while others don’t? It could be the ones that don’t are engaged in a lot of research and development, and a lot of proprietary information that would be difficult to credibly communicate to independent directors, or maybe they don’t want to for proprietary reasons. It makes sense for that company to have a majority of non-independent directors.
Armstrong: One practical implication is, where do the independent directors get the information that they’re using? We use a variety of measures that are relatively common in the corporate finance literature. We look at analysts’ forecasts. We look at management forecasts and management is often an information source in terms of the frequency with which they issue forecasts are made, or the precision. We look at evidence from stock market trades. We also look at some accounting measures in terms of audited financial reports. So, those are all different pieces that go into the information mix that directors and especially independent directors draw on for when they’re making their decisions.
Guay: What that means from the corporation’s perspective is that if the corporation is trying to put in some changes with respect to governance — if they’re thinking about changing their board structure or adding new directors to the board — they need to be cognizant of these informational issues.
They need to give some thought to this: How are we going to make sure that those busy people that have a limited amount of time to spend with us are making good decisions? It’s in management’s best interests to make sure that the board is informed, because otherwise they’re voting and imposing their power over management without the information to move the firm in the right direction.
So, this research says something about what firms should be thinking about when they’re making these changes to corporate governance. It also could potentially guide regulators, who’ve been making a lot of changes to corporate governance. Over the last 10 or 15 years, regulators have decided that the majority of every public board of directors will be comprised of a majority of independent directors; the audit committee needs to be 100% independent directors. The compensation committee needs to be 100% independent directors. The committee for nominating board members needs to be comprised of 100% independent directors.
The regulators have been, over the last 10 or 15 years, imposing more and more cost, risk, time on these independent directors. More and more of the decision-making in public corporations is in the hands of independent directors. And that’s only going to work if those independent directors have the information that they need. Regulators need to be cognizant of that as well when they’re imposing governance standards.
The impacts of transparency:
Armstrong: Another regulatory aspect that we take as a given in our paper is there have also been regulatory changes over the last 15 years with respect to what’s disclosed about governance. What I have in mind in particular is that compensation disclosures have gotten a lot better and a lot more transparent over the last 15 years.
We, as researchers — and presumably shareholders, analysts, regulators — have a lot more information about what the compensation package of the CEO and the top executives looks like, for example. To the extent that these other actors are also doing some of the monitoring , that information is potentially facilitating their decision-making, their monitoring.
On today’s empowered shareholders:
Armstrong: Shareholder voting has gotten a lot of attention in the business press lately. One specific example is on pay voting. Companies have to put the CEO’s compensation package to a shareholder vote once every three years. In the U.S., it’s a non-binding vote. But it is a way for shareholders to express their sentiment about the compensation package.
That’s symptomatic of what seems to be a push towards more shareholder empowerment. In terms of governance, giving shareholders more voting. And in light of our research, that raises the question: Just like with independent directors, we need to think about where are they getting their information? When you’re talking about dispersed shareholders who have potentially smaller stakes, less of an incentive to monitor — where are they getting their information?
How are they going to be processing it? That’s something that needs to be kept in mind if regulators, for example, are going to push for more shareholder empowerment.
The information environment isn’t as ‘fixed’ as once thought:
Guay: The reason the paper made a contribution to the academic literature in this area was it built on prior literature that argued that the information environment that a firm was wrapped up in was essentially fixed or exogenous to the firm. And that prior literature argued that there was really very little that the firm or the board could do to alter the amount of transparency between the board and the firm.
What that literature argued is that, in firms that aren’t very transparent, they simply can’t have a lot of independent directors, and in firms that are fairly transparent, they can. Now, that literature is primarily in finance. Coming at it from an accounting perspective, there’s a lot of accounting literature that focuses very closely on how firms can make financial reporting decisions and alter the auditing process to make the firm more transparent when it’s not.
“We’ve seen lots of cases where managers get up to some financial shenanigans …. In those very important settings, in the very settings where you’d like to get the best information, managers are not going to give you that information.” –Wayne Guay
We think that it is possible for the board of directors to step in and make some changes, for management to make some changes that could facilitate more independent directors. I made the point earlier that it kind of goes in both directions.
The information environment dictates the proper governance structure to be put in place in terms of board independents, but board independents likewise can influence the information environment. And so, the two things tend to work together, move together.
Next steps in the research – applying these lessons to banks:
Armstrong: We’re working on a survey paper talking about governance in particular in the context of financial institutions and banks. We’re trying to apply some of what we learned from this paper and other papers in the literature in the context of banks and financial institutions in particular.
That raises some interesting issues, [because] financial institutions have an inherent level of complication and complexity that most other organizations don’t have. From an accounting perspective their financial statements tend to be longer, a lot more is disclosed in the footnotes. There’s a lot more information. The information processing demands are presumably much higher in that setting. That raises a question: How do independent directors acquire, process this information in an inherently complex, potentially opaque institution?
In the financial institutions setting, there are also the regulators who play a very important role, and to some extent can substitute for some of these other governance mechanisms. They’re another set of eyes on management, and they have informational demands as well. And thinking about how those are going to get resolved becomes very important.
Guay: Just putting in a little bit more context. In the wake of the financial crisis, one of the concerns was that managers were up to certain things, taking certain risks that shareholders and the board were not aware of.
There was a concern that the information, the transparency wasn’t there between what managers were up to and what the board and what shareholders knew. And so, the bank regulators have tried to move forward on that and see what they can do about it.
We’ve brought in a co-author who works with the Federal Reserve Bank of New York, and this paper will be published with him. And there, we do focus on specific issues that banks face that are unique to banks, and trying to move forward on increasing transparency between the board of directors and shareholders, and potentially even regulators and managers.
The risks of not getting good information:
Guay: The independent director also needs to think about their own personal reputation and the risks that they face. One of the biggest costs of being an independent director is yes, you have to put in some time. But you’re [also] concerned that if something goes bad, you’re going to be blamed for it and you could be litigated against. You could be sued. And it could severely damage your reputation.
“Where are [ordinary shareholders] getting their information? How are they going to be processing it? That’s something that needs to be kept in mind if regulators … are going to push for more shareholder empowerment.” –Christopher Armstrong
So, those independent directors are only going to want to sit on a board where they feel that they’re going to be getting good information. If you thought just using the public information that’s available about a firm, I don’t think any of us would feel like we could make strategic decisions for that company just by looking at their SEC filings. You need a much deeper, richer set of information.
So those outside directors come in, and they have to get themselves up to speed. They are typically interviewed by management. They’re interviewed by the existing board of directors. And then once they sit on the board, they have regular meetings with managers. Managers present budgets. Managers present ideas. Managers present lots of things. And that certainly is a very important sort of channel by which information would get conveyed to the directors.
In most situations, that might be a perfectly reasonable place for directors to get information. But where they’re concerned is — we’ve seen lots of cases where managers get up to some financial shenanigans or some earnings management or doing things that they shouldn’t be doing. In those very important settings, in the very settings where you’d like to get the best information, managers are not going to give you that information.
So your channel for getting information about things that the managers don’t want you to know pretty much gets shut down. The board needs to then figure out, “How do we ensure that the tires have been kicked properly, if you will?” There are lots of people that are looking at the firm. Analysts are looking at the firm. Auditors are looking at the firm. Regulators are looking at the firm. Creditors are looking at the firm. Suppliers, employees — there’s lots of different institutional shareholders. There might be some hedge funds or private equity, or a large bloc of shareholders that have investments.
So, all of those individuals and institutions are kicking the tires. The board wants to make sure that you have enough of those other people out there kicking the tires that they can potentially ferret out things or figure out things that the board members just either don’t have the time or the information or simply can’t do themselves.
So it’s a very complicated information environment. But the key issue to remember — that the thing you care most about as a director if you’re trying to do some monitoring is making sure you get information when managers are least likely to want to give it to you.
Armstrong: Arguably, one of the most [important] jobs of the board of directors is hiring and firing the CEO. And that’s a great example of an instance where you can’t rely on them to give you the information that you need to make the right decision.